Note to readers: Only the charts and the Market Summary change from week to week. All other text remains the same, in order to allow regular readers to quickly absorb the entire Brief.

Periodically we take some time to reconcile some of the varied options indicators available for the S&P 500. These indicators are unique to zentrader, and were developed in order to give readers an edge in the stock market.

These indicators were meant to be tangible – easily understood at a glance – thus providing an instant snapshot of the stock market to anyone regardless of trading experience, or the lack of experience.

Taking the Stock Market’s Temperature

First, we take the stock market’s Temperature. We need to know if the stock market is hot right now, or if it has cooled off. In other words, is this a hot Bull market in which stock prices are going up, or a cold Bear market in which stock prices are tumbling?

To take the Temperature of the S&P 500, we look at the performance of a simple option trade known as a Covered Call. Covered Call trading is almost always profitable in a Bull market, and very often results in losses in a Bear market. Conversely, if Covered Calls* are profitable it is currently a Bull market, and if Covered Calls are returning losses it is a Bear market.

We consider the point at which Covered Call trading breaks even – returns zero profit and zero loss – to be an S&P 500 Temperature of zero. Then we determine whether the S&P 500 is above or below that all-important break-even point. By measuring the distance of the current level of the S&P 500 from the break-even point we determine the Temperature. Above zero indicates a Bull market; below zero indicates a Bear market is in progress.

A historical 10-year chart of the S&P 500 Temperature shows its importance as an indicator. Not only are Bear markets highly-correlated with sub-zero Temperatures, the sub-zero readings often occur before stock prices have broadly declined 20%. Furthermore, the Temperature rarely falls below zero during a Bull market, so no matter how severe a pullback occurs in a Bull market, the uptrend almost always continues as long as the Temperature doesn’t dip much below the zero mark.

Temperature Determines Trading Climate

Next, we use the S&P 500 Temperature to determine the type of trading environment that is most likely to be prevalent in the stock market. Perhaps not surprisingly, hotter temperatures tend to coincide with a more positive outlook, thus more exuberance for those buying stocks. Lower Temperatures tend to correlate with fear and a propensity to sell stocks.

It should be noted that the Temperature ranges above represent a continuum. That is to say, they are not written in stone. For example, a Temperature of 1 degree below zero does not somehow magically represent a shift to a Bear market. Nevertheless, the ranges have been historically accurate in a wide variety of market environments for well over a decade.

All stock-market indicators are prone to fail at times, and the Temperature is no different. Though rare, below zero readings have occurred outside of Bear markets. Most recently, the S&P 500 Temperature dipped below zero in October 2014 without an accompanying Bear market ensuing, one of only a few such occurrences in past decades.

Once we have associated the current Temperature with the current Stage of the market, it is possible to plot that Stage on a graph.

Trading Climate fits Elliott Wave Analysis

Traders often use an Elliott Wave analysis to help determine the reason for current trends in the stock market. Because traders act as a herd, and because herds tend to react in a somewhat predictable pattern, stock prices tend to follow a pattern as well. That pattern can sometimes be reasonably outlined using the Elliott Wave theory.

Here we use the current S&P 500 Temperature to determine the current Stage of the stock market. Then we mark the most appropriate spot on a typical Elliott Wave which correlates to previously-calculated Stage.

Since most S&P 500 Temperatures can only be achieved during one specific Options Market Stage, choosing the current location on the Elliott Wave is simply a matter of matching the current Stage to the Wave. Some Temperatures, though, can occur in a number of different Options Market Stages, and require some additional insight.

For example, Bull Market Stage 2 and Bull Market Stage 0 each occur at a Temperature between +125 and +200. As can be seen on the Elliott Wave above, Bull Market Stage 0 only occurs after a major decline in stock prices has bottomed out, while Bull Market Stage 2 occurs when stock prices are consistently rising. Thus, we can usually differentiate Stage 0 from Stage 2 by knowing how the market has been behaving in recent weeks.

Similarly, a Temperature of 0 to +75 is associated with four different Options Market Stages:

Bull Market Stage 3 occurs only when stock prices have recently risen but have hit a brick wall of resistance and are having trouble rising further.

Bull Market Stage 5 occurs only after stock prices have tested a major support (such as the 200-day simple moving average) without sinking into a Bear market.

Bear Market Stage 6 occurs only after stock prices have fallen well below a major support (200-day simple moving average) and then recovered quickly in a matter of days or weeks.

Bear Market Stage 9 occurs only after a protracted period of declining stock prices lasting many weeks or months.

Taking into account those extra bits of information, it then becomes possible to determine the current Options Market Stage rather accurately. Plotting it on the Elliott Wave chart then becomes just as accurate. We can then use the Options Market Stage calculated above to determine the current trading environment in the stock market.

Click on chart to enlarge

Since the market is now rather bearish, using the Elliott Wave as a guide, we may find it helpful to plot the expected movement of the S&P 500 based on past Bear markets.

Verifying the Analysis

As can be seen on the Elliott Wave graph, the “You Are Here” sign points to a specific combination of profit and loss on some simple option strategies.

Covered Calls and Naked Puts

Long Calls and Married Puts

Long Straddles and Strangles

If the S&P 500 Temperature has allowed us to choose our current location on the Elliott Wave graph correctly, we should be able to verify it by looking at the performance of those three strategies.

The following chart shows the current performance of each of those three strategies using at-the-money options opened 4-months ago on $SPY (NYSEARCA:SPY) which expire this week.

To further illustrate the current stock market trading environment, we can break down the chart of the Options Market Stages to show the individual performance of each of the three options strategies.

The performance of Covered Calls and Naked Puts shows us whether the current stock market is most likely to predominantly have either a bullish or a bearish sentiment.

The performance of Long Calls and Married Puts tells us exactly how strong or weak any bullish sentiment is likely to be.

The performance of Long Straddles and Long Strangles indicates whether the current trend is over-extended (and needs to back off a little, or “correct”), whether the current market has become excessively range-bound (and needs to break out of the range) or whether it is normal (neither in urgent need of a correction nor in need of a breakout). It should be noted that a correction during a downtrend usually entails rising prices, and is the reverse of a correction during an uptrend which usually entails a decrease in prices.

#CCNPI – The S&P 500 Covered Call/Naked Put Index

#LCMPI – The S&P 500 Long Call/Married Put Index

#LSSI – The S&P 500 Long Straddle/Strangle Index

Market Summary

The S&P 500 has not gone outside the boundaries of Bear Market Stage 6 since mid-October. That speaks to the validity of Stage 6 being a good definition of the current stock market environment. If the S&P had gone outside those boundaries, it could easily be argued that the boundaries themselves were irrelevant; but instead they appear to remain extremely relevant.

Bear Market Stage 6 typically occurs only during the first several months of a new bearish downtrend for stock prices – a downtrend that can last for many months to a year or more – also known as a Primary Bear Market. Such downtrends commonly occur within the confines a broader Secular Bull Market in which stock prices are rising over a longer time frame of five years or more.

Despite the limited time frame for the downtrend, a Primary Bear Market in which stock prices broadly decline 20% or more off their highs can be a major event for traders. The Financial Collapse of 2008 lasted less than two years, yet it wreaked havoc on many traders’ portfolios. The presence of Bear Market Stage 6 suggests such a downtrend is currently underway, though the stage itself does not suggest the severity of the downtrend is comparable to the 2008 event.

As long as Stage 6 is underway, it is an indication that the downtrend has some unfinished business – that further declines in stock prices are a good possibility in coming months. This potential for coming sell-offs in stocks is based on historical records going back two decades, in which Stage 6 tended to precede steep declines for stocks and for the S&P 500 as a whole.

To quote from the definition of Bear Market Stage 6 shown on the Options Market Stages chart above:

Stock prices have bounced off of lows, but implied volatility (VIX) is high. Profitability of Covered Calls and Naked Puts is bullish, but Long Calls and Married Put losses indicate no bullish strength. Long Straddle and Strangle losses signal a possible upcoming breakout, usually to lower prices.

While the VIX is not excessively high at the moment, it has not returned to the extreme low levels (near 10) that preceded the major downturn that began August 24, 2015. The VIX is currently in the upper teens, indicative that fear of additional sell-offs in stocks remains much higher now than it was in early August, prior to the downturn. The fear remains elevated now, despite the fact that the majority of stocks have fully recovered from the downturn, and many have gone on to set new all-time highs.

Expiring ATM 4-month Covered Calls* on the S&P 500 index have become profitable once again in recent weeks. This profitability occurred after several weeks of losses. Generally, those specific Covered Calls only return losses during a Bear Market. Since they returned some significant losses, and since those losses were relentless for an extended period lasting approximately three months from August through October, it is a strong indication that a Bear market is indeed underway at the moment. But because the recent sell-off never took the S&P to the threshold of 20% off its high – the common definition of a Bear market – the worst may be yet to come.

During Bear Market Stage 6, Covered Call trading generally becomes profitable. Indeed, Covered Calls are profitable whenever the S&P 500 Temperature is above zero, and the first weekly Temperature above zero defines the beginning of Stage 6. The profitability of Covered Calls is always a bullish sign. It correlates with bullish emotions among traders. But, such bullishness is always unsustainable as long as Stage 6 remains underway.

Long Call trading is profitable only when traders have a high amount of confidence in their own bullishness. Bullish strength allows traders to weather the occasional news event, such as a poor earnings event from a major corporation, and to do so without panic. Long Call trading is never profitable during Bear Market Stage 6. Thus, without the confidence that accompanies Long Call profits, any bad economic development has the potential to cause a major sell-off in stocks. Traders always lack confidence during Stage 6.

Long Call trading can only return to profitability if the S&P enters Bull Market Stage 0 (the black zone on the chart of the Options Market Stages). Until that occurs, the S&P 500 is walking on thin ice. The slightest crack in the ice can start a chain reaction in which bullish traders, lacking confidence, sell their stocks. The selling causes stock prices to fall. The falling prices spook other bullish traders, causing them sell their stocks as well, leading to even steeper declines in stock prices.

Often times such a panic will reach a point of equilibrium and the chain reaction will quit before stock prices have tumbled excessively. Indeed, as long as Bear Market Stage 6 is underway traders will generally want to be bullish. They will want to buy stocks on a dip. That’s what bullish traders do. They simply lack confidence. As soon as stock prices bounce off of support, they’ll climb back in and start buying stocks again.

All traders have their limits though. Push them too far and they’ll walk away. During every chain reaction panic there is a point of no return. Should stock prices fall beyond that point, many bullish traders, traders who want to buy stocks, who might have bought stocks at the first sign of a bounce off of support, will have already have walked away. Without those same traders entering orders to buy, the bounce off of support will not be sustainable.

Generally, when Covered Call trading becomes unprofitable, that marks the point of no return. That’s the point at which traders move their funds to cash and take the day off to go fishing.

Covered Call trading, as a rule, is profitable not just when stock prices are rising or flat, but also when stock prices are falling at a reasonable rate. Only when the rate of decline becomes unreasonably steep does Covered Call trading result in losses. That’s what makes it such a good indicator of sentiment. Covered Call losses correlate with an environment in which traders want to take the day off and go fishing. Stock prices are falling unreasonably fast. Why stick around?

Covered Call losses occur whenever the S&P 500 Temperature is below zero. Thus, a Temperature of zero or below, especially when it is sustained for a week or more, tends to coincide with the point of no return. When too many traders go fishing instead of buying stocks, that’s when the chain reaction panic loses equilibrium. If there are too few traders willing to buy stocks, it’s “look out below” for stock prices.

Covered Call losses occur at the very start of every Bear market. However, the first Covered Call loss does not result in the “look out below” effect for stocks. It does cause panic, and stock prices do tumble, but since the first Covered Call loss comes out of the blue, often with a great sense of surprise. The first Covered Call loss causes traders to exclaim “Oh No!” as they watch stock prices fall.

When the second Covered Call loss comes around just a few weeks or more after the first loss, the element of surprise has disappeared. Traders are quick to take the “fool me once, shame on you; fool me twice, shame on me” attitude. They are quick to shut down their trading platforms and pick up the fishing pole. The second Covered Call loss marks the start of Bear Market Stage 7 – the “look out below” stage (the red zone on the chart of the Options Market Stages). Bear Market Stage 7 is more violent, with steeper and deeper declines in stock prices than Bear Market Stage 5, because, quite simply, many more of the potential buyers of stocks have gone fishing. There are simply too few bidders to accommodate those with shares to sell unless the sellers lower their asking prices.

As long as the S&P 500 remains within the boundaries of Bear Market Stage 6, stock prices may have violent but ultimately unsustainable rallies. There may also be violent but unsustainable sell-offs. The result will be a sideways drift, perhaps a choppy sideways drift, perhaps a choppy and slow melt in one direction or the other. But the moment the S&P moves outside the boundaries, things will become sustainable very quickly.

If the S&P moves above Bear Market Stage 6, into the black zone of Bull Market Stage 0, rallies will quickly become sustainable and support levels will become strong.

Currently, an S&P 500 Temperature above approximately +125 would correlate with the start of Bull Market Stage 0.

If the S&P moves below Bear Market Stage 6 into the red zone of Bear Market Stage 7, sell-offs will become sustainable and support levels will become faint or disappear altogether.

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca